Macroeconomics For Dummiesđ, UK Edition Published by: John Wiley & Sons, Ltd., The Atrium, Southern Gate, Chichester, www.wiley.com This edition first published 2015 â 2016 John Wiley & Sons, Ltd, Chichester, West Sussex Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher Wiley publishes in a variety of print and electronic formats and by print-ondemand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Designations used by companies to distinguish their products are often claimed as trademarks All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners The publisher is not associated with any product or vendor mentioned in this book LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: WHILE THE PUBLISHER AND AUTHOR HAVE USED THEIR BEST EFFORTS IN PREPARING THIS BOOK, THEY MAKE NO REPRESENTATIONS OR WARRANTIES WITH THE RESPECT TO THE ACCURACY OR COMPLETENESS OF THE CONTENTS OF THIS BOOK AND SPECIFICALLY DISCLAIM ANY IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE IT IS SOLD ON THE UNDERSTANDING THAT THE PUBLISHER IS NOT ENGAGED IN RENDERING PROFESSIONAL SERVICES AND NEITHER THE PUBLISHER NOR THE AUTHOR SHALL BE LIABLE FOR DAMAGES ARISING HEREFROM IF PROFESSIONAL ADVICE OR OTHER EXPERT ASSISTANCE IS REQUIRED, THE SERVICES OF A COMPETENT PROFESSIONAL SHOULD BE SOUGHT For general information on our other products and services, please contact our Customer Care Department within the U.S at 877-762-2974, outside the U.S at (001) 317-572-3993, or fax 317-572-4002 For technical support, please visit www.wiley.com/techsupport Library of Congress Control Number: 2015950120 ISBN 978-1-119-02662-4 (paperback); ISBN 978-1-119-02667-9 (ebk); ISBN 978-1-119-02668-6 (ebk) Macroeconomics For Dummies® Visit www.dummies.com/cheatsheet/macroeconomicsuk to view this book's cheat sheet Table of Contents Cover Introduction About This Book Foolish Assumptions Icons Used in This Book Beyond the Book Where to Go from Here Part I: Getting Started with Macroeconomics Chapter 1: Discovering Why Macroeconomics Is a Big Deal The Big Picture: Checking Out the Economy as a Whole Looking at the Key Macroeconomic Variables Modelling the Economy Plotting Economic Policy Financial Crises! Going Wrong on a Global Scale Chapter 2: Looking at Key Questions and Concepts Seeing the Questions that Intrigue Macroeconomists Thinking Like an Economist: Learning to Love Modelling Clarifying Important Macroeconomic Concepts Chapter 3: Curing a Sick Economy of Four Afflictions Reading about Recessions Getting Hyper about High Inflation Finding Out about Financial Crises Uncovering Unemployment: Causes and Responses Part II: Measuring the Things that Matter Chapter 4: Totting up a Country’s Economic Activity: Gross Domestic Product Grasping the Idea of GDP Getting Out What You (Marginally) Put In Calculating GDP: Assessing an Economy’s Health Measuring Living Standards with GDP and Other Methods Chapter 5: Facing the Fact of Increasing Prices: Inflation Working Out Inflation: Looking into the Average Shopping Basket Examining the Cause of Inflation: The Quantity Theory of Money Appraising Inflation: Good or Bad? Rising to Extremes: Hyperinflation Going Downwards: Deflation Chapter 6: Unemployment: Wasting Talent and Productivity Understanding the Importance of Unemployment: Opportunity Cost Comparing Two Different Measures of Unemployment Distinguishing Two Different Types of Unemployment Reducing the ‘Natural’ Rate of Unemployment Part III: Building a Model of the Economy Chapter 7: Working Out a Country’s Economic Demand Looking into What Everyone Wants: Aggregate Demand Meeting the Components of Aggregate Demand Following the Aggregate Demand Curve Chapter 8: Determining How Much Stuff an Economy Can Produce Producing What People Demand: Aggregate Supply Looking at Long-Run Aggregate Supply Getting to Grips with Short-Run Aggregate Supply Chapter 9: Using the AD–AS Model to Analyse Shocks to the System Discovering What the AD–AS Model Does and Doesn’t Explain Delving into Demand-Side Shocks Bumping into Supply-Side Shocks Part IV: Examining Macroeconomic Policy Chapter 10: Using Monetary Policy to Influence the Economy Seeing Monetary Policy in Action Exerting Control over Inflation Spotting the Liquidity Trap and Quantitative Easing Reeling in the Fisher Effect Chapter 11: Fiscal Policy: Balancing the Books – Perhaps Delving into Fiscal Policy Taking in Two Views of Fiscal Policy Chapter 12: Seeking Low Unemployment and Low Inflation: The Phillips Curve Boosting the Economy: A Good Strategy for Low Unemployment? Zeroing in on the Short- and Long-Run Phillips Curve Taking Action with Disinflation Policy Chapter 13: Following Rules or Using Discretion: Two Approaches to Economic Policy Introducing the Rules versus Discretion Debate Discerning the Problems with Discretion Solving the Problem: Tying Your Hands Voluntarily Part V: Understanding the Financial Crisis Chapter 14: Considering Fundamental Weaknesses of the Financial System Understanding Weaknesses in the Financial System Finding Out about Fractional Reserve Banking Catching a Cold! Systemic Risk Chapter 15: Getting Away with Excessive RiskTaking: Moral Hazard Banks Behaving Badly: Watching Out for Moral Hazard Avoiding Financial Armageddon: Bailouts Providing Incentives for Excessive Risk-Taking Committing to No Bailouts (Dream On!) Chapter 16: Considering the Lessons of the 2008 Financial Crisis Delving into the Global Financial Crisis Asking Why Economists Didn’t Predict the Crisis Trying to Stop the Next Crisis Part VI: The Part of Tens Chapter 17: Getting to Know Ten Great Macroeconomists Adam Smith (1723–1790) John Maynard Keynes (1883–1946) Milton Friedman (1912–2006) Paul Samuelson (1915–2009) Robert Solow (born 1924) Robert Lucas (born 1937) Edward Prescott (born 1940) Robert Barro (born 1944) Robert Hall (born 1943) Janet Yellen (born 1946) Chapter 18: Ten Top Tips to Take Away Factoring in Factors of Production Paying Factors of Production Their Marginal Products Understanding that Excessive Growth in the Money Supply Causes High Inflation Minimising Unemployment (Though Some Is Inevitable) Stimulating Aggregate Demand Can Increase Output Only in the Short Run Accepting that Financial Crises Are Certain and Impossible to Predict Seeing that No Trade-Off Exists between Inflation and Unemployment in the Long Run Discovering Why Policy Makers Should Constrain Themselves Fixing the Financial System without Solving Moral Hazard Is Impossible Recognising that, Ultimately, Real Things Are What Count About the Authors Cheat Sheet Advertisement Page Connect with Dummies End User License Agreement Introduction Macroeconomics is the study of the economy as a whole So if you want to understand key concepts that you come across every day in the news, such as inflation, unemployment and economic growth, this is the book for you! This book helps you to tackle some of the biggest questions people ask about macroeconomics, such as Why are some countries rich and others poor? And what can poor countries do to become richer? What causes the prices of things to rise and fall? Why are some people unable to find work? And what can be done to reduce unemployment? Why is there so much inequality in the world and what can we do about it? We don’t pretend to have answers to all the questions, but we do think that macroeconomics provides some good answers to many questions about how the economy works Fortunately, some of the world’s greatest minds have worked on macroeconomics and created a substantial body of work Sadly, economists (and we’re just as guilty) haven’t done a great job at communicating the key ideas of macroeconomics to the public As a result, all too often politicians and commentators are able to bamboozle people with nice-sounding but ultimately bad economics The point of this book is to introduce you to the fascinating world of macroeconomics so you can see how the economy works in reality, how you fit into it and, perhaps, ultimately how the world can be made a better place About This Book Macroeconomics affects almost every part of your life Whether you have a job or are unemployed, whether you earn millions or the minimum wage, whether you want to borrow money or earn income from your savings, macroeconomics matters to you Banks are so interconnected that trouble at one can easily spread to many others This problem is known as contagion Crises are also very difficult, if not impossible, to predict The reason is the Efficient Market Hypothesis, which says that the current price of a financial asset already contains within it all publicly known information Thus, if predicting a financial crisis occurring (say) next year were possible, it would cause a crisis right now, as people would rush to sell their financial assets Chapters 14 to 16 contain all you want (or fear you need) to know about financial crises Seeing that No Trade-Off Exists between Inflation and Unemployment in the Long Run The Phillips curve relationship (which we describe in Chapter 9) tells economists that in the short run policy makers can reduce unemployment below its natural rate by creating surprise inflation Therefore, they may be able to reduce it by pursuing expansionary fiscal/monetary policy (Chapters 10 and 11 have lots more) But any reduction in unemployment is short-lived In the long run, unemployment is always equal to its natural rate, so inflating the economy in this way leads only to one thing: higher inflation Thus policy makers should resist the temptation to reduce unemployment below its natural rate To help people, policy makers need instead to reduce the natural rate of unemployment by making labour markets more flexible (see ‘Minimising Unemployment (Though Some Is Inevitable)’ earlier in this chapter) Discovering Why Policy Makers Should Constrain Themselves Economists think that people are pretty smart As a result, they believe that policy makers can fool people now and again, but shouldn’t be able to fool them persistently For example, policy makers can create some surprise inflation and reduce unemployment below the natural rate But after they’ve done that once, people realise what the sneaky policy makers are up to and fooling them a second time is much more difficult – everyone now expects inflation to be high So, not only is inflation high, but also unemployment isn’t reduced Policy makers may be better off constraining themselves by following a fixed set of rules instead of using their discretion (check out Chapter 13 for more) Following rules gives their announcements credibility: they’re bound to do what they say they’re going to do Therefore, when policy makers announce that inflation is going to be low, people believe that inflation is going to be low, which then leads to inflation being low in reality Fixing the Financial System without Solving Moral Hazard Is Impossible The financial system has serious problems (but unless you’ve been living under a rock for the last eight years, you know that!) The problem of systemic risk (if one large bank fails, many banks may fail) means that financial institutions (especially large ones) face a moral hazard problem: they have incentives to take on excessive risk in the knowledge that governments are likely to bail them out if things go pear-shaped Without solving the moral hazard problem, fixing the financial system is impossible Unfortunately, it’s a very difficult problem A number of solutions have been proposed, including these two: Breaking up large banks: The idea is to reduce systemic risk so that governments can commit credibly not to bail out a failing bank If a bank goes under, so be it The hope is that, with this knowledge, the bank itself doesn’t want to take on excessive risk Forcing banks to take less risk: Introducing regulations, such as requiring banks to hold a greater proportion of their deposits in reserve The idea is that this will substantially reduce the probability of a bank failure Recognising that, Ultimately, Real Things Are What Count This point is especially important People shouldn’t care about nominal things – they should care about real things Here are some examples: Real wage: What really matters about your wage is how much stuff you can buy with it, not its numerical value So if your boss offers you a 5-per cent pay rise when inflation is running at 10 per cent, you’re getting a raw deal: your real pay will fall by 5 per cent Real interest rate: When you’re borrowing (or saving), the real interest rate is what matters, not the nominal interest rate, because the real interest rate tells you the cost of borrowing in terms of goods, not in terms of money Money is useful only for buying goods, and so this is what counts Real Gross Domestic Product (GDP): The value of goods and services produced in a country rises over time due to inflation, even if the total quantity and quality of those goods are unchanged Saying that this situation represents an increase in a nation’s productive capacity or its living standards would be silly Therefore, macroeconomists focus on real GDP (that is, GDP adjusted for the effects of inflation) Chapter 4 has all the gen on GDP About the Authors Manzur Rashid read economics at Trinity College, Cambridge, where he graduated with a double first and was elected to junior, senior and research scholarships He completed his doctoral studies in economic theory at University College London (UCL) under the supervision of Martin Cripps, where he specialised in game theory, bounded rationality and industrial organisation Manzur has taught economics at UCL, Cambridge University, New College of the Humanities and Charterhouse Peter Antonioni is a senior teaching fellow in the Department of Management Science and Innovation at UCL, where he teaches strategy His research interest focuses on the economic history of music production When not working, he can usually be found crying over Tottenham Hotspur’s most recent performance or channelling his angst into playing blues guitar Dedications For Ilyas —Manzur Rashid To Tanya, Mum, Dad, Paul and Jen, who suffered most from me writing this — Peter Antonioni Authors’ Acknowledgements Manzur Rashid: I am grateful to all the people at Wiley who have helped us get this book into shape, including Mike Baker, Simon Bell, Steve Edwards, Andy Finch, Annie Knight, Kate O’Leary and Vicki Adang I am also grateful to Ron Smith for his helpful suggestions and comments Thanks to my friends and family for their endless support Finally, thank you to my teachers: Martin Cripps, Hamish Low, Rupert Gatti, Steve Satchell, Gernot Doppelhofer and Kevin Sheedy Peter Antonioni: With many thanks to the support of my colleagues at UCL, and to the many economists who once had to explain patiently all this material to me Publisher’s Acknowledgements Commissioning Editor: Annie Knight Project Managers: Simon Bell, Victoria M Adang Development Editor: Andrew Finch Copy Editor: Kate O’Leary Technical Editor: Ron Smith Project Coordinator: Antony Sami Cover Image: ©iStock.com/Jezperklauzen To access the cheat sheet specifically for this book, go to www.dummies.com/cheatsheet/macroeconomicsuk Find out "HOW" at Dummies.com Take Dummies with you everywhere you go! Go to our Website Like us on Facebook Follow us on Twitter Watch us on YouTube Join us on LinkedIn Pin us on Pinterest Circle us on google+ Subscribe to our newsletter Create your own Dummies book cover Shop Online WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA ... ISBN 978-1-119-02662-4 (paperback); ISBN 978-1-119-02667-9 (ebk); ISBN 978-1-119-02668-6 (ebk) Macroeconomics For Dummies Visit www .dummies. com/cheatsheet/macroeconomicsuk to view this book's cheat sheet Table of Contents Cover... John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material... macroeconomic knowledge to putting the world to rights! Part I Getting Started with Macroeconomics Visit www .dummies. com for free access to great Dummies content online In this part … Discover why macroeconomics is important and get an overview of